Another Look at US-German Rate Differentials

diffsThis chart, created on Bloomberg, depicts the interest rate differential between the US and Germany.  The euro-dollar exchange rate often seems sensitive to the rate differential.  The white line is the two-year differential and the yellow line is the 10-year differential.

 There are a few observations to share.  First, the 10-year premium is often greater than the two-year premium.  It has been five years since this was not the case.  However, as the chart shows presently, the two-year premium is greater.  The US offers about 205 bp more than Germany at the short-end of the coupon curve and about 195 bp on 10-year money.

Second, both differentials have begun moving back in the US favor.  The two-year differential widened from about 193 bp on May 18 to 206 bp today.  The 10-year premium has widened from about 185 bp on May 17 to nearly 195 bp today.  It is not so much a one-to-one correspondence between rate differentials and a particular exchange rate level.  Rather, we often find the direction is more important than level.

Third, the euro appears to be potentially turning.  For four sessions it knocked on $1.1285, trying to clear $1.13, with some talk of a move back to $1.16, last year’s high.     The euro is softening and the RSI and MACDs warned of more downside risk ahead of next week’s FOMC meeting.  The euro has slipped below its 20-day moving average (~$1.1190) for the first time since April 18.   It has retraced more than 61.8% of the last leg up that began at the end of May from $1.1110.  That retracement objective was $1.1180.  A break of the $1.1100 area could quickly see $1.1050.    There is a potential double top in the euro and the $1.1110 is the neck line.  If valid, the measuring objective of the pattern is near $1.0935.